BMO Financial Analysis & Risk Evaluation 2 — Questions and Answers
Question 1: A company has a current ratio of 0.8. What does this indicate about its short-term liquidity?
- The company has strong liquidity with excess current assets
- The company may struggle to meet short-term obligations (Correct answer)
- The company is highly profitable
- The company has no long-term debt
Correct answer: The company may struggle to meet short-term obligations
A current ratio below 1.0 means current liabilities exceed current assets, signaling potential difficulty covering short-term debts.
Question 2: Which financial metric best measures how efficiently a company uses its assets to generate revenue?
- Return on equity (ROE)
- Asset turnover ratio (Correct answer)
- Debt-to-equity ratio
- Price-to-earnings ratio
Correct answer: Asset turnover ratio
Asset turnover ratio (Revenue ÷ Total Assets) measures how efficiently a company generates sales from its asset base.
Question 3: In credit risk analysis, what does a borrower's 'debt service coverage ratio' (DSCR) of 1.25 mean?
- The borrower has 25% more income than needed to service debt (Correct answer)
- The borrower is 25% over their credit limit
- The borrower's debt exceeds income by 25%
- The borrower has defaulted on 25% of obligations
Correct answer: The borrower has 25% more income than needed to service debt
A DSCR of 1.25 means the borrower generates $1.25 in net operating income for every $1.00 of debt service, indicating a 25% cushion.
Question 4: What is the primary purpose of stress testing in financial risk management?
- To maximize portfolio returns under normal market conditions
- To evaluate how a portfolio performs under extreme adverse scenarios (Correct answer)
- To determine the optimal asset allocation for growth
- To compare performance against benchmark indices
Correct answer: To evaluate how a portfolio performs under extreme adverse scenarios
Stress testing simulates extreme but plausible adverse conditions to assess potential vulnerabilities in a portfolio or institution.
Question 5: A company's EBITDA margin decreased from 22% to 16% year-over-year despite revenue growth. What is the most likely cause?
- Improved operational efficiency
- Rising operating costs outpacing revenue growth (Correct answer)
- Increased interest expense
- Higher depreciation charges
Correct answer: Rising operating costs outpacing revenue growth
EBITDA margin compression despite revenue growth typically signals that operating expenses (COGS, SG&A) are rising faster than revenue.
Question 6: Which type of risk refers to losses resulting from inadequate internal processes, systems failures, or human error?
- Market risk
- Credit risk
- Operational risk (Correct answer)
- Liquidity risk
Correct answer: Operational risk
Operational risk encompasses losses from internal failures including process breakdowns, system errors, fraud, and human mistakes.
Question 7: When performing a discounted cash flow (DCF) analysis, increasing the discount rate will generally:
- Increase the present value of future cash flows
- Decrease the present value of future cash flows (Correct answer)
- Have no effect on the valuation
- Increase the terminal value
Correct answer: Decrease the present value of future cash flows
A higher discount rate reduces the present value of future cash flows because future money is worth less in today's dollars at a higher rate.
BMO Financial Analysis & Risk Evaluation 2
A company has a current ratio of 0.8.
What does this indicate about its short-term liquidity?